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Premium

Richard C. Grinold

Former Managing Director

Barclays Global Investors

Kenneth F. Kroner

Managing Director

BlackRock

Laurence B. Siegel

Research Director, Research Foundation of CFA Institute

Senior Advisor, Ounavarra Capital LLC

The equity risk premium (ERP) is almost certainly the most important variable

in finance. It tells you how much you need to save, how much you can spend,

and how to allocate your assets between equities and bonds. Yet, recognized

experts cannot agree on the ERP’s value within an order of magnitude or even

agree whether it is negative or positive. At a 2001 symposium, the predecessor

of the one documented in this book, Robert Arnott and Ronald Ryan set forth

an ERP estimate of –0.9 percent and Roger Ibbotson and Peng Chen proposed

+6 percent.1 The estimates in this book are much more tightly clustered, but

considerable disagreement remains about how to estimate the premium as well

as its size.

Grinold and Kroner (2002) proposed a model of the ERP that linked equity

returns to gross domestic product (GDP) growth.2 The key insight, which

draws on earlier work by a number of authors, was that aggregate corporate

profits cannot grow indefinitely much faster—or much slower—than GDP.

(And as Herbert Stein was fond of reminding us, any economic trend that

cannot continue forever will not.) If profits grow faster than GDP, they

eventually take over the economy, leaving nothing for labor, government,

natural resource owners, or other claimants. If profits grow more slowly than

1 See Arnott and Ryan (2001); Ibbotson and Chen (2003). The Ibbotson and Chen estimate of

6 percent is an arithmetic mean expectation; their geometric mean expectation was 4 percent.

2 A second printing of this article, from March 2004, is available online at www.cfapubs.org/

userimages/ContentEditor/1141674677679/equity_risk_premium.pdf.

ERP.book Page 54 Wednesday, December 21, 2011 9:06 AM

GDP, they eventually disappear and businesses will have no profit motive to

continue operating. Thus, in the very long run, the ratio of profits to GDP is

roughly constant.

The title of this paper, a shortened and updated version of Grinold and

Kroner (2002), refers to the “supply model” of Diermeier, Ibbotson, and Siegel

(1984), who differentiated between the demand for capital market returns (what

investors need to compensate them for risk) and the supply of returns (what the

macroeconomy makes available). The original supply model likewise made use

of a link between profits and GDP. Grinold and Kroner (2002) was titled “The

Equity Risk Premium: Analyzing the Long-Run Prospects for the Stock

Market,” but the similarity with the title of this book forced us to rename the

current paper. Although our method is designed to produce an ERP estimate

that reflects both supply and demand, the link to macroeconomic performance

gives it a supply-side flavor.3

When we revisited the estimates from Grinold and Kroner (2002), we

found that not all the components could be updated with equal accuracy, so the

ERP estimate provided here is subject to some important caveats regarding data

adequacy. The method that we recommend, however, remains largely

unchanged from Grinold and Kroner (2002).

We define the equity risk premium as the expected total return differential

between the S&P 500 Index and a 10-year par U.S. government bond over the

next 10 years. Our forecast of the return to the 10-year government bond over

the next 10 years is simply the yield on that bond. Therefore, the ERP becomes

E RS RB = Expected S&P 500 return 10-year bond yield . (1)

A purer and more “modern” approach is to conduct the whole analysis in

real terms and to use the yield on a 10-year par Treasury Inflation-Protected

Securities (TIPS) bond or, alternatively, a 10-year TIPS strip as the relevant

bond yield. The authors of some of the other papers in this book do just that.

We estimate the ERP over 10-year nominal bonds, however, because that is

what Grinold and Kroner (2002) did. The numerical difference between the

results of the two methods, real and nominal, is not large.

Forecasting the return on the S&P 500 over the next 10 years is more

difficult and, therefore, gets most of the attention in this paper. The framework

we use is to decompose equity returns into several understandable pieces and

then examine each piece separately.

3 A more detailed history of the estimation of the ERP can be found in the foreword (by Laurence

B. Siegel) in Kaplan (2011).

ERP.book Page 55 Wednesday, December 21, 2011 9:06 AM

The return to equities over a single period can always be broken down as

RS Income return Nominal earnings growth Repricing. (2)

The income return is the percentage of market value that is distributed to

shareholders as cash. If dividends are the only source of income, then the income

return is equivalent to the dividend yield. Today, share repurchase programs

(buybacks) are another common means of distributing cash to shareholders.

Cash takeovers (by one company of another) should also be counted in the

income return of an index that includes the stock of the acquired company.

The next two terms in Equation 2 represent the capital gain. Capital gains

come from a combination of earnings growth and P/E expansion or contraction,

which we call “repricing.”

For expository purposes, we decompose the components further and use

more precise notation. The return over a single period is

D

R S i g PE .

P

(3)

Income Earnings growth Repricing

The first term, D/P, is simply the dividend yield. The second term, –S,

is the percentage change in the number of shares outstanding. The percentage

change in the number of shares outstanding equals the “repurchase yield”

(which theoretically also includes cash takeovers) minus new shares issued

(dilution); it has a negative sign because a decrease in the number of shares

outstanding adds to return and an increase subtracts from return.4 Together,

the terms D/P and –S measure the fraction of market capitalization that the

companies in an index, in aggregate, return to shareholders in cash. Therefore,

we refer to the sum of these two terms as the “income return.”

The remaining terms, i + g + PE, make up the capital gain. The term i

represents the inflation rate. The term g is the real earnings (not earnings per

share) growth rate over the period of measurement. The final term, PE, is

the percentage change in the P/E multiple over the period. We refer to this

last piece as the “repricing” part of the return.

4 Share buybacks may be viewed as either a component of income return or a component of capital

gain. An owner of a single share who holds on to the share through the share buyback program

experiences the buyback as a component of capital gain because the same earnings are divided

among fewer shares, which causes EPS to rise although earnings (not per share) have not

changed. If the stock’s P/E and all other factors are held equal, then the stock price rises. An

index fund investor, however, experiences the share buyback as cash income because the index

fund manager—who tenders some of the shares to the issuer to keep the stock’s (now decreased)

weight in the fund proportionate to its weight in the index—receives cash, which is then

distributed to, or held by, fund shareholders like any other cash (tax considerations aside). We

choose to view share buybacks as a component of income return.

ERP.book Page 56 Wednesday, December 21, 2011 9:06 AM

identity, not an assumption, so any view on the equity risk premium can be mapped

into these components. To illustrate, if the current 10-year bond yield is 3 percent,

anyone who believes that the ERP is currently 4 percent must believe that the

income return, nominal earnings growth, and repricing sum to 7 percent.

Historical Returns

Let us briefly consider what risk premium markets have provided historically.

Over the last 85 years (1926–2010), the U.S. stock market and the intermediate-

term U.S. Treasury bond market have delivered compound annual nominal

returns of 9.9 percent and 5.4 percent, respectively.5 Thus, the realized pre-

mium that stocks delivered over bonds was 4.5 percent.6 The historical return

decomposition in Table 1 can be used to better understand this 9.9 percent

annual equity return.

The income return (through dividends only, not share buybacks) on the

S&P 500 was 4.1 percent annualized over this 85-year period. In this decom-

position, we adjusted earnings growth for increases in the number of shares to

arrive at earnings per share (EPS) growth. EPS grew at a rate of about 4.9 percent

per year (1.9 percent real growth and 3.0 percent inflation) over the period.

S&P 500,a 1926–2010

Income return 4.10%

Real EPS growth 1.91

Inflation 2.99

P/E repricing 0.58

Within-year reinvestment returnb 0.28

Total return 9.87%

aS&P 90 from January 1926 to February 1957; S&P 500 from

March 1957 to 2010.

bReinvestment of dividends paid during the year in the capital gain

index (which consists of real EPS growth plus inflation plus P/E

repricing).

Source: Morningstar/Ibbotson (used by permission).

5 See the data for large-company stocks (i.e., the S&P 90 from January 1926 through February

1957 and the S&P 500 thereafter) in Table 2.1 in Ibbotson SBBI (2011, p. 32). Returns are

before fees, transaction costs, taxes, and other costs.

6 This amount is the arithmetic difference of geometric means. The geometric difference of

geometric means, or the compound annual rate at which stocks outperformed bonds, is given by

(1 + 0.099)/(1 + 0.054) – 1 = 4.27 percent.

ERP.book Page 57 Wednesday, December 21, 2011 9:06 AM

The remainder of the total return on equities was due to repricing. The

P/E of the market, measured as the end-of-year price divided by trailing

12-month earnings, grew from 11.3 at year-end 1925 to 18.5 at year-end

2010.7 This repricing works out to an additional return, or P/E expansion, of

0.58 percent per year. A common view is that this P/E expansion was

understandable and reasonable in light of the technological and financial

innovations over this long period. For example, accounting standards became

more transparent (recent “fraud stocks” notwithstanding). Such innovations

as the index fund made it easier for investors to diversify security-specific risk

and to save on costs. Mutual fund complexes provided easier access to institu-

tional-quality active management. Finally, many market observers perceive the

business cycle to have been under better control in recent decades than it was

in the 1920s and 1930s, which made expected earnings smoother; the recent

near depression and quick recovery, at least in corporate profits and the stock

market, support this view somewhat. All these factors have made equity

investing less risky and contributed to the repricing over this 85-year period.

But the presence of these factors in the past does not mean that we should

build continued upward repricing into our forecasts. We consider this issue later

in this paper.

Chart 1 of Grinold and Kroner (2002) further dissects the return decom-

position into annual return contributions. Their graph demonstrates that the

noisiest component of returns is clearly P/E repricing, followed by real earnings

growth. Inflation and income returns are relatively stable through time. This

observation implies that our real earnings growth and repricing forecasts are

likely to be the least accurate and our inflation and income return forecasts are

likely to be more accurate.

Mehra and Prescott (1985), and many others, argued that the equity

premium of 4.5 percent was a multiple of the amount that should have been

necessary to entice investors to hold on to the risky cash flows offered by equities

instead of the certain cash flows offered by bonds. This contention spawned a

huge literature on the “equity risk premium puzzle.”8 We have always been

perplexed by a debate that suggests that investors were wrong while a specific

macroeconomic theory is right, but Rajnish Mehra sheds additional light on

this question elsewhere in this book.

7 Because earnings were growing very quickly at the end of 2010, the more familiar P/E calculated

as the current price divided by 12-month forward (forecast) earnings was lower than the P/E

shown here.

8 For surveys of this literature, see Kocherlakota (1996); Mehra (2003).

ERP.book Page 58 Wednesday, December 21, 2011 9:06 AM

Next, we will examine each term in Equation 3 to determine which data are

needed to forecast these terms over the moderately long run (10 years). Later

in the paper, we will combine the elements to estimate, or forecast, the total

return on the S&P 500 over that time frame. Finally, we will subtract the

10-year Treasury bond yield to arrive at the expected equity risk premium.

Income Return. The income return is the percentage of market capi-

talization that is distributed to shareholders in cash. Currently, companies have

two principal means of distributing cash to shareholders: dividend payments

and share repurchases. A third method, buying other companies for cash,

“works” at the index level because index investors hold the acquired company

and the acquiring company if the index is broad enough.

Until the mid-1980s, dividends were essentially the only means of distrib-

uting earnings. Since then, repurchases have skyrocketed in popularity, in part

because they are a more tax-efficient means of distributing earnings and in part

because companies with cash to distribute may not want to induce investors to

expect a distribution every quarter (and cutting dividends is painful and often

causes the stock price to decline). In addition, dividend-paying companies may

suffer from a stigma of not being “growth” companies.

In fact, according to Grullon and Michaely (2000), the nominal growth rate

of repurchases between 1980 and 1998 was 28.3 percent. Numerous other studies

have shown that share repurchases have surpassed dividends as the preferred

means of distributing earnings.9 According to Fama and French (2001), only

about one-fifth of publicly traded (nonfinancial and nonutility) companies paid

any dividends at the time of their study, compared with about two-thirds as

recently as 1978. So the “repurchase yield” now exceeds the dividend yield.

Currently (as of 18 March 2011), the dividend yield is 1.78 percent.10 Like

a bond yield, the current (not historical average) dividend yield is likely the best

estimate of the income return over the near to intermediate future, so we use

1.78 percent as our estimate of D/P in Equation 3.

To estimate the repurchase yield, we used historical data over the longest

period for which data were available from Standard & Poor’s, the 12 years from

1998 through 2009. We calculated the annual repurchase yield as the sum of a

given year’s share repurchases divided by the end-of-year capitalization of the

market. Table 2 shows these data. The average of the 12 annual repurchase

yields is 2.2 percent, which we use in our ERP estimate.

9 See, for example, Fama and French (2001); Grullon and Michaely (2000); Fenn and Liang (2000).

10 We obtained this number at www.multpl.com/s-p-500-dividend-yield on 18 March 2011.

ERP.book Page 59 Wednesday, December 21, 2011 9:06 AM

Year-End Market Share Repurchases Share Repurchase

Capitalization during Year Return

Year ($ billions) ($ billions) (%)

1998 9,942.37 125 1.26

1999 12,314.99 142 1.15

2000 11,714.55 151 1.29

2001 10,463.39 132.21 1.26

2002 8,107.41 127.25 1.57

2003 10,285.83 131.05 1.27

2004 11,288.60 197.48 1.75

2005 11,254.54 349.22 3.10

2006 12,728.86 431.83 3.39

2007 12,867.85 589.12 4.58

2008 7,851.81 339.61 4.33

2009 9,927.56 137.60 1.39

Average 2.20

Source: Standard & Poor’s.

It is possible to make the case for a much higher repurchase yield forecast

by giving greater weight to more recent information (which is basically what

we did with the dividend yield). According to Standard & Poor’s (2008), “Over

the past fourteen quarters, since the buyback boom began during the fourth

quarter of 2004, S&P 500 issues have spent approximately $1.55 trillion on

stock buybacks compared to . . . $783 billion on dividends.” Although buybacks

collapsed in 2009, they rebounded in 2010 and 2011. If the two-to-one ratio

of buybacks to dividend payments observed by Standard & Poor’s over 2004–

2008 persists in the future, the repurchase yield will be as high as 3.5–3.6

percent. Aiming for a “fair and balanced” estimate, we use the lower number,

2.2 percent, which we obtained by weighting all 12 years of historical share

repurchase data equally.11

We have not included cash buyouts in our estimate of the repurchase yield.

From the perspective of an investor who holds an index containing companies

A, B, C, and so forth, a cash buyout or takeover—a payment by company A to

11 The use of this lower number is neutral, not conservative in the sense of numerically

minimizing the ERP estimate. The reason is that there are offsetting biases. Our buyback

estimate of 2.2 percent is too high because we do not subtract the historical contribution of

buybacks to the dilution estimate (discussed later). And it is too low because very recent buyback

rates have been much higher than 2.2 percent, not to mention the fact that we fully ignore the

cash takeover yield.

ERP.book Page 60 Wednesday, December 21, 2011 9:06 AM

shares—is no different from a share buyback, which is a payment by company

A to an investor holding shares of A in exchange for a tender of those shares.

Thus, the “cash buyout yield” needs to be added to the repurchase yield when

summing all the pieces of –S. However, we do not have data for cash buyouts.

If we did, they would increase our forecast of the equity risk premium (because

cash buyouts must be a positive number and no other component of the ERP

would change).

■ Effect of Dilution on Income Return. Dilution is the effect of new issu-

ance of shares by existing companies and takes place through secondary offer-

ings and the exercise of stock options. Dilution may be regarded as reflecting

capital that needs to be injected from the labor market (or from elsewhere) into

the stock market so investors can participate fully in the real economic growth

described in the next section. Formally, dilution (expressed as an annual rate or

a decrement to the total expected equity return) is the difference between the

growth rate of dividends and the growth rate of dividends per share. If the

payout ratio is assumed to be constant, dilution is also equal to the difference

between the earnings growth rate and the EPS growth rate.

Grinold and Kroner (2002) estimated dilution from secondary offerings

using historical data and dealt with stock options separately. Here, because we

do not have the data to properly update the dilution estimates in Grinold and

Kroner (2002), we use a shortcut: We directly adopt the 2 percent per year

dilution estimate from Bernstein and Arnott (2003).

Bernstein and Arnott (2003) studied U.S. stocks from 1871 to 2000 and

stocks from other countries over shorter periods. Instead of measuring the

difference between the growth rate of earnings and that of EPS, they used a

proxy: They measured the difference between the growth rate of total market

capitalization and the capital appreciation return (price return) on existing

shares. Dilution thus measured is net of share buybacks and cash buyouts (which

are forms of negative dilution because giving cash back to shareholders is the

opposite of raising capital by selling shares). The 2 percent dilution estimate

for U.S. stocks is supported by evidence from other countries.12

12 For a fuller discussion of dilution and an excellent description of the Bernstein and Arnott

(2003) method, see Cornell (2010), who wrote, “Bernstein and Arnott (2003) suggested an

ingenious procedure for estimating the combined impact of both effects [the need of existing

corporations to issue new shares and the effect of start-ups] on the rate of growth of earnings to

which current investors have a claim. They noted that total dilution on a marketwide basis can

be measured by the ratio of the proportionate increase in market capitalization to the value-

weighted proportionate increase in stock price. More precisely, net dilution for each period is

given by the equation Net dilution = (1 + c)/(1 + k) – 1, where c is the percentage capitalization

increase and k is the percentage increase in the value-weighted price index. Note that this dilution

measure holds exactly only for the aggregate market portfolio” (p. 60).

ERP.book Page 61 Wednesday, December 21, 2011 9:06 AM

historical dilution that was due to buybacks and cash takeovers (but not the part

of dilution that was due to stock option issuance because these cash flows went

to employees, not shareholders). We do not have the data to perform these

adjustments, however, so we do not attempt them. We simply use the 2 percent

estimate. (Note that the number of buybacks was tiny until the mid-1980s—

that is, over approximately the first 115 years of the 130-year sample—so

historical buybacks probably had a minimal impact on the average rate of

dilution for the entire period.)

■ Numerical Estimate of Income Return. The income return forecast con-

sists of the expected dividend yield, D/P, minus the expected rate of change in

the number of shares outstanding, S. The expected dividend yield is 1.78

percent. The number of new shares is expected to decline at a –0.2 percent

annual rate, consisting of 2 percent dilution minus a 2.2 percent repurchase

yield. After adding up all the pieces, the income return forecast is 1.98 percent.

real earnings growth, and real GDP growth—all expressed in aggregate, not in

per share or per capita, terms—to be equal to each other.

We expect dividend and earnings growth to be equal because we assume a

constant payout ratio. Although the payout ratio has fluctuated widely in the

past, it has trended downward over time, presumably because of tax and

corporate liquidity considerations. But the decline has effectively stopped.

Figure 1 shows the dividend payout ratio for the U.S. stock market for 1900–

2010; this curious series looks as though it has been bouncing between a

declining lower bound (which has now leveled off near 30 percent) and an

almost unlimited upper bound. The highest values of the payout ratio occurred

when there was an earnings collapse (as in 2008–2009), but companies are loath

to cut dividends more than they have to.13 The lower bound reflects payout

policy during normally prosperous times.

The current lower bound of about 30 percent would be a reasonable forecast

of the payout ratio, but we do not need an explicit forecast because we have

already assumed that it will be constant over the 10-year term of our ERP

estimate. It is helpful to have empirical support for our assumption of a constant

payout ratio, however, and the recent relative stability of the lower bound in

Figure 1 provides this support.

13 The all-time high level of the payout ratio, 397 percent, occurred in March 2009, when

annualized monthly dividends per “share” of the S&P 500 were $27.25 and annualized monthly

earnings per “share” were $6.86.

ERP.book Page 62 Wednesday, December 21, 2011 9:06 AM

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0

1900 10 20 30 40 50 60 70 80 90 2000 10

as of 4 November 2011); calculations are by the authors.

We expect real earnings growth to equal real GDP growth for the macro-

consistency reason stated earlier: Any other result would, in the very long run,

lead to an absurdity—corporate profits either taking over national income

entirely or disappearing. Figure 2 shows the (trendless) fluctuations in the

corporate profit share of GDP since 1947.

These observations leave us with the puzzle of forecasting real GDP

growth. Grinold and Kroner (2002) engaged in a fairly typical macroeconomic

analysis that involved productivity growth, labor force growth, and the expected

difference between S&P 500 earnings and overall corporate profits. They did

not use historical averages or trends directly as forecasts; rather, they argued

that the data plus other factors justified the conclusion that real GDP would

most likely grow at 3 percent over the relevant forecast period and that real S&P

500 earnings would grow at 3.5 percent.

Real economic growth, by definition, equals real productivity growth plus

labor force growth. Although we can update the historical productivity and

labor force growth numbers, doing so would not produce an especially useful

forecast any more than it did for Grinold and Kroner (2002), who distanced

themselves somewhat from the productivity and labor force growth approach.

The reason is that extrapolating recent trends in these components of eco-

nomic growth can produce unrealistically high or low expectations, and using

ERP.book Page 63 Wednesday, December 21, 2011 9:06 AM

of GDP, 1947–2010

Profits/GDP (%)

15

13

11

5

47 50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10

Source: Haver Analytics, citing U.S. National Income and Product Accounts data.

components, which are important. Nevertheless, updates of these components

are provided for informational purposes in Figure 3.

We can, however, use a different decomposition of real economic growth,

which is also definitional: Expected GDP growth equals expected per capita GDP

growth plus expected population growth. We believe that population growth is

easier to forecast than labor force growth because the latter is partly endogenous

(e.g., people work longer if they need the money because of a weak economy).14

Figure 4 shows that since 1789, real per capita U.S. GDP has grown at a

fairly constant 1.8 percent compound annual rate. Cornell (2010) arrived at a

global estimate from the high-growth postwar period (1960–2006) that is

higher, but not dramatically so: 2.42 percent for mature economies and 2.79

percent for emerging economies. A cautious forecast is that the 1.8 percent

growth rate will continue. If this forecast entails substantial risk, it is to the

upside because an investment in the S&P 500 is not a pure bet on the U.S.

economy; many, if not most, of the companies in the index are global companies

that sell to markets that are growing more rapidly than the U.S. market.

14 Population growth is also partly endogenous (because the decisions of how many children to

have, whether to emigrate, and so forth, may depend on economic performance). These effects,

however, operate with long lags and tend to move the population growth rate slowly.

ERP.book Page 64 Wednesday, December 21, 2011 9:06 AM

Figure 3. U.S. Real Productivity and Labor Force Growth Rates, 1971–2009

4

Labor Force Growth Real Productivity Growth

3

–1

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09

Source: Organisation for Economic Co-Operation and Development, OECD StatExtracts (http://

stats.oecd.org/Index.aspx, as of 14 November 2011: total labour force, U.S., and labour productivity

annual growth rate, U.S.).

100,000

10,000

1,000

100

1789 1819 1849 1879 1909 1939 1969 1999

ERP.book Page 65 Wednesday, December 21, 2011 9:06 AM

We add to the 1.8 percent real per capita GDP growth estimate the

Economist Intelligence Unit 10-year U.S. population growth estimate of 0.85

percent,15 which gives a total real GDP growth forecast of 2.65 percent. This

number is slightly below current consensus estimates.

This simplified method presents some difficulty because if the rate of

dilution is 2 percent at all population growth rates, then population growth has

a one-for-one effect on the estimate of the expected return on equities and,

therefore, on the ERP. This suggests an easy beat-the-market strategy: Invest

only in countries with the fastest population growth. This strategy has not

worked well in the past, and even if it did over some sample period, easy beat-

the-market strategies are usually illusory. Thus, the dilution estimate should

probably be higher for countries with high population growth rates or for a

country during periods of above-normal population growth. Although the logic

of using a link to real GDP growth to forecast the stock market has great

intuitive appeal, putting it into practice with any precision will take more work

and more thought regarding dilution.16

Expected Inflation. Because we are deriving the ERP relative to

Treasury bonds, we do not need our own inflation forecast as much as we need

an estimate of the inflation rate that is priced into the 10-year Treasury bond

market. Historical inflation rates have no bearing on this number, so we do

not present them. Fortunately, the yield spread between 10-year nominal

Treasury bonds and 10-year TIPS is a direct, although volatile, measure of the

inflation rate that is expected by bondholders. (The spread also includes an

inflation risk premium, present in nominal bond yields but not in TIPS yields,

for which we need to adjust.)

15 This number was obtained at http://7marketspot.com/archives/2276 on 2 May 2011 under

the heading “USA economy: Ten-year growth outlook” in the column “2011–20.” If we instead

used real productivity growth plus labor force growth to estimate real GDP growth, we would

get a slightly higher number for real productivity growth and a slightly lower number for labor

force growth, which would provide a very similar overall real GDP forecast.

16 Our simplified method has some other characteristics worth noting. It does not specifically

account for the wedge between population growth and labor force growth if the proportion of

retirees (or children) in the population is expected to change. A growing unproductive retiree

population should be considered bearish. Many would-be retirees, however, are not financially

prepared for retirement and, willingly or not, will work longer than they originally anticipated,

which contributes to GDP. In addition, in an advanced technological society, an aging

population distribution within the workforce is not all bad! We are accustomed to thinking of

young workers as productive and older workers as unproductive, but this is the case only in a

fairly primitive economy where the primary job description is something like “lift this and put it

over there.” In a technological society, young workers are unproductive—often startlingly so,

earning only the minimum wage—and older workers produce most of the added value and make

the lion’s share of the money. Nevertheless, young workers’ productivity grows quickly and older

workers’ productivity grows slowly or shrinks, so the impact of an aging workforce on rates of

change in productivity may be less salutary than the impact on the level of productivity.

ERP.book Page 66 Wednesday, December 21, 2011 9:06 AM

On 22 April 2011, the breakeven inflation rate (the yield spread described

above) was 2.60 percent.17 This rate is high by recent standards—it was as low

as 1.5 percent in September 2010—but it is typical of the longer history of the

series. Recent concerns about very high and rapidly growing levels of public

indebtedness (of the U.S. government, of local governments in the United States,

and of non-U.S. governments) have contributed to the increase in inflation

expectations. We subtract 0.2 percent for the inflation risk premium to arrive at

a 2.4 percent compound annual inflation forecast over the next 10 years.18

Expected Repricing. Grinold and Kroner (2002, p. 15, Chart 8)

conducted an analysis of the market’s P/E that led them to include a nonzero

(–0.75 percent per year) value for the repricing term, PE, in Equation 3. At

the time the analysis was conducted (November 2001), the market’s conven-

tional trailing P/E (price divided by one-year trailing earnings) was a lofty 29.7

and the “Shiller P/E” (price divided by 10-year trailing real earnings) was 30.0,

which prompted the authors to conclude that the P/E was likely to decline.19

(The Shiller P/E is designed to smooth out fluctuations caused by yearly

changes in earnings.) And decline it did.

Today, the situation is different. Figure 5 shows the conventional P/E and

the Shiller P/E of the U.S. market. Today’s conventional P/E of 18.5 is only

modestly higher than the very long-run (1900–2010) average P/E of 15.7, and

it is lower than the more recent long-run (1970–2010) average P/E of 18.9.

The Shiller P/E tells a slightly less favorable story: The current value is 22.4,

compared with an average of 16.3 over 1900–2010 and 19.2 over 1970–2010.20

Because it averages 10 years of trailing earnings, however, the current Shiller

P/E includes an earnings collapse in 2008–2009 that is almost literally unprec-

edented; even the Great Depression did not see as sharp a contraction in S&P

composite index earnings, although overall corporate profits in 1932 were

negative. (Huge losses in a few large companies, such as those that occurred in

2008–2009, go a long way toward erasing the profits of other companies when

summed across an index.) Only the depression of 1920–1921 is comparable.

Thus, we see no justification for using a nonzero value for the repricing term

in Equation 3. The market’s current level is already reflected in the (low)

dividend yield. To include a repricing term even though the dividend yield

already incorporates the market’s valuation is, theoretically, not double-counting

because the influence of the dividend yield is amortized over an infinite horizon,

17 See www.bloomberg.com/apps/quote?ticker=USGGBE10:IND.

18 This estimate of the inflation risk premium comes from Hördahl (2008, p. 31, Graph 2).

19 Shiller (2000) describes the Shiller P/E.

20 In this section, “current” values are as of December 2010.

ERP.book Page 67 Wednesday, December 21, 2011 9:06 AM

Figure 5. Conventional and Shiller P/Es for the U.S. Equity Market,

1900–2010

P/E

50

45

40

35 Shiller

30

25

20

15

10

5 Conventional

0

1900 10 20 30 40 50 60 70 80 90 2000 10

Source: Spreadsheet available at Robert Shiller’s website (www.econ.yale.edu/~shiller/data/ie_data.xls).

whereas our forecast is for only the next 10 years. Thus, if we believe that the

market is mispriced in such a way that it will be fully corrected within 10 years,

a nonzero repricing term is warranted. Although Grinold and Kroner (2002)

argued that the market P/E was too high at that time and would decline at an

expected rate of 0.75 percent per year over the forecast horizon, we think the

market is currently not too high (or too low), and our repricing forecast is zero.

In this section, we estimate the expected total nominal return on equities, as

expressed in Equation 3, using the inputs we derived in the foregoing sections.

We then subtract the 10-year nominal Treasury bond yield to arrive at our

estimate of the ERP over the next 10 years.

Income return (D/P – S) = 1.78 percent dividend yield

– (–0.2 percent repurchase yield net of dilution)

= 1.98 percent.

Capital gain (i + g + PE) = 2.4 percent inflation

+ 1.8 percent real per capita GDP growth

+ 0.85 percent population growth

= 5.05 percent.

ERP.book Page 68 Wednesday, December 21, 2011 9:06 AM

= 7.03 percent (rounded to 7 percent)

– 3.40 percent 10-year Treasury bond

on 22 April 201121

= 3.6 percent expected ERP over 10-year Treasuries.

Our forecasts thus far have been geometric means (rG ). To estimate the

equivalent arithmetic mean return expectation (rA ) for use as an optimizer

input, we rely on the following approximation:

2

1 rG 1 rA . (4)

2

We use standard deviations drawn from 1970 to 2010 because we do not

necessarily expect bond returns to be as placid as they have been recently. Thus,

for the purpose of estimating standard deviations, we include this long period

because it includes the bond bear market of 1970–1980 and the dramatic

subsequent recovery.22 We obtain the following:

Expected arithmetic mean equity total return = 8.59 percent.

Expected arithmetic mean 10-year Treasury bond total return = 3.96 percent.

Difference (expected arithmetic mean ERP) = 4.63 percent.

A limitation of this study is that we use U.S., not global, macroeconomic

data in our estimate of the expected return on the S&P 500. The S&P 500 is

a global index, in that it contains many companies that earn most, or a

substantial share, of their profits outside the United States. Perhaps global

economic growth rates are more relevant to the expected return on the S&P

500 than U.S. growth rates. Future research should examine this possibility.

Grinold and Kroner (2002) identified three camps of ERP forecasters: “risk

premium is dead,” “rational exuberance,” and “risk is rewarded.” They called the

first two views “extreme” and wished to be counted among the moderate “risk is

rewarded” camp, in keeping with the belief that markets are generally efficient

and that prices, therefore, do not stray far from genuine values for very long.

22 Stocks = 17.68 percent; bonds = 9.73 percent (these data are from Aswath Damodaran’s

website, http://pages.stern.nyu.edu/~adamodar, as of 3 June 2011).

ERP.book Page 69 Wednesday, December 21, 2011 9:06 AM

Grinold and Kroner’s (2002) forecast, evaluated over 2002–2011, was too

high. The main problem was the volatile repricing term. They seriously under-

estimated the speed with which the unusually high P/Es that then prevailed

would revert toward their historical mean. In this paper, we forecast a repricing

of zero, consistent with our view that the market is finally, after two bear

markets and two recoveries, roughly fairly priced. Because the repricing term is

noisy, we know that our current forecast is more likely to be too high or too low

than just right when evaluated over the next 10 years. We believe, however, that

we have identified the middle of the range of likely outcomes. Although black

swans, fat tails, and tsunamis are the talk of the day, such large unexpected

events tend to fade in importance as they are averaged in with less dramatic

events over extended periods and the underlying long-term trends reveal

themselves once more.23 We expect moderate growth in the stock market.

contribution of a number of different data sources and for his wise counsel.

Paul Kaplan also provided helpful advice and contributed invaluable data.

R EFERENCES

Arnott, Robert D., and Ronald J. Ryan. 2001. “The Death of the Risk Premium.” Journal of

Portfolio Management, vol. 27, no. 3 (Spring):61–74.

Bernstein, William J., and Robert D. Arnott. 2003. “Earnings Growth: The Two Percent

Dilution.” Financial Analysts Journal, vol. 59, no. 5 (September/October):47–55.

Cornell, Bradford. 2010. “Economic Growth and Equity Investing.” Financial Analysts Journal,

vol. 66, no. 1 (January/February):54–64.

Diermeier, Jeffrey J., Roger G. Ibbotson, and Laurence B. Siegel. 1984. “The Supply of Capital

Market Returns.” Financial Analysts Journal, vol. 40, no. 2 (March/April):74–80.

Fama, Eugene F., and Kenneth R. French. 2001. “Disappearing Dividends: Changing Firm

Characteristics or Lower Propensity to Pay?” Journal of Financial Economics, vol. 60, no. 1

(April):3–43.

Fenn, George W., and Nellie Liang. 2000. “Corporate Payout Policy and Managerial Stock

Incentives.” Working paper, Federal Reserve Board (March).

Grinold, Richard C., and Kenneth F. Kroner. 2002. “The Equity Risk Premium: Analyzing the

Long-Run Prospects for the Stock Market.” Investment Insights, vol. 5, no. 3 (July):7–33.

ERP.book Page 70 Wednesday, December 21, 2011 9:06 AM

Grullon, Gustavo, and Roni Michaely. 2000. “Dividends, Share Repurchases and the Substitu-

tion Hypothesis.” Unpublished manuscript, Johnson Graduate School of Management, Cornell

University (April).

Hördahl, Peter. 2008. “The Inflation Risk Premium in the Term Structure of Interest Rates.”

BIS Quarterly Review (September):23–38.

Ibbotson, Roger G., and Peng Chen. 2003. “Long-Run Stock Returns: Participating in the Real

Economy.” Financial Analysts Journal, vol. 59, no. 1 (January/February):88–98.

Ibbotson SBBI. 2011. 2011 Classic Yearbook: Market Results for Stocks, Bonds, Bills, and Inflation,

1926–2010 (Chicago: Morningstar).

Kaplan, Paul D. 2011. Frontiers of Modern Asset Allocation. Hoboken, NJ: John Wiley & Sons.

Kocherlakota, Narayana R. 1996. “The Equity Premium: It’s Still a Puzzle.” Journal of Economic

Literature, vol. 34, no. 1 (March):42–71.

Mehra, Rajnish. 2003. “The Equity Premium: Why Is It a Puzzle?” Financial Analysts Journal,

vol. 59, no. 1 (January/February):54–69.

Mehra, Rajnish, and Edward C. Prescott. 1985. “The Equity Premium: A Puzzle.” Journal of

Monetary Economics, vol. 15, no. 2 (March):145–161.

Shiller, Robert J. 2000. Irrational Exuberance. 2nd ed. Princeton, NJ: Princeton University Press.

Siegel, Laurence B. 2010. “Black Swan or Black Turkey? The State of Economic Knowledge

and the Crash of 2007–2009.” Financial Analysts Journal, vol. 66, no. 4 (July/August):6–10.

Standard & Poor’s. 2008. “S&P 500 Stock Buybacks Retreat in Q1 but Remain Strong.” Press

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